Market Wrap, Saturday, 04/25/2009 Traders Stressing Over the Test by Jim Brown Click here to email Jim

HAVING TROUBLE PRINTING?

It was a rocky week for the markets with the Dow making two complete tests of support at 7800 as traders worried how the financial stress test would change the banking sector.

Market Statistics

There was a dramatic buildup to the release of the stress test details at 2:PM on Friday. Drum roll please. Better yet cue the dramatic music of your choice from Jaws, Star Wars or Terminator and get ready for the historic announcement. Two o'clock arrives and a TV commentator gives us the six sentences of stress test scenarios and it is on to the next topic. That was it, nothing new and nothing dramatic. No big earth shaking news that suggested a handful of banks might be taken over or nationalized. No major hurdle that each would have to jump.

The stress test scenario was basically an analysis of how banks would perform under two different scenarios. The first was the Capital Assistance Program (CAP) baseline scenario and the one they feel most likely will occur. The second scenario forced them to estimates losses and capital requirements under a more adverse case list of possibilities. This was not "worst case" but an "adverse case." This distinction was made clear that there could be a darker possibility but nobody was planning for it.

The scenarios are listed in the table below. The CAP baseline assumes the economy will begin recovering in the second half and offset some of the dire numbers from the first quarter leaving the GDP down only -2% for the year. The unemployment rate in the baseline scenario was not expected to decline materially from the 8.5% we have today. Even in the adverse case the unemployment levels were not expected to rise dramatically considering some analysts are already predicting over 10% in 2010. The home prices were the biggest hurdle. The baseline assumes a -14% drop in 2009 and another -4% drop in 2010. Those would be very painful on top of the drops we have already experienced. The adverse case drop of -22% and -7% would be extremely ugly and has the potential to cause the most pain for banks. With record numbers of foreclosures already another -22% drop in prices would be catastrophic. This also happens to be Dr Doom's prediction and he has not missed one in a very long time.

Stress Test Table

Banks were asked to predict capital requirements for the given scenarios. They were also asked to plan for keeping a capital buffer in place to cover an unexpected economic decline. Given what we know about the financial conditions of banks today it is a sure bet that more government capital will be needed or at least forced upon some banks. By late Friday analysts were asking if the $135 billion left in the TARP program would be enough to provide the capital cushion for the weak banks. Several of the big banks continue to ask to be allowed to return the TARP money and the government continues to say not yet.

Fed officials held top-secret meetings with bank executives to give them the preliminary findings of how each bank would fare if the recession got much worse. The Fed reinforced its view that the top 19 banks were too big to fail and it would do whatever necessary to save them. However, the Fed stressed in a statement that the need to raise additional capital should not be considered a measure of "current solvency or viability of the bank." Let's hope not or Citibank would already be insolvent.

The results will be released on May 4th by the government. In an interesting twist the banks are now "prohibited by law" from publicizing the results of the test without specific government permission. That seems extremely strange to me that they would be prohibited by law from discussing their own financial condition. The government has got to quit taking itself so seriously. Except in the case of Citibank it does not own the banks. Passing these laws retroactively on a whim is an obscene misuse of power.

Critics are now wondering if the government is not creating the opposite of what it is trying to do. The object was to build confidence in the banking community and by cloaking the outcome in secrecy and warning repeatedly that the results don't signify insolvency you have to wonder what or whom they are protecting. Analysts are already producing a list of banks that they expect will fail the test or at lease be required to raise more capital. The banks get the final results on May 1st and have two days to review the results and appeal the findings.

One measure used by the Fed in this analysis is the Tangible Common Equity or TCE of a bank. The Fed wants it to be over 3%. That is 3-cents of tangible common equity for every dollar in assets. That is leverage of 33:1. At least five of the top 19 banks are seriously deficient in that area. PNC has a TCE of 2.3%, BAC 2.3%, BK 2.1%, WFC 1.4% and Citigroup 1.4%. Unfortunately TCE has no standard definition other than all intangibles have to be removed and the Fed could make up its own definition to allow banks to escape the test. The Fed is also going to allow the banks to value assets according to their own guidelines. Not a mark-to-market but more of a mark-to-myth valuation.

What this leave us with is another week of leaks, rumors, conjecture and supposition before the (cue the dramatic music) "official" results are released on May 4th. The White House said only the "applicable" results would be released. Does this mean the negative results are going to be concealed? We already know that nobody is going to actually fail but the key is how much capital will they be forced to raise? With the Treasury on a "loans for shares" trend now that means severe dilution for those common shareholders unlucky enough to be holding a bank forced to take on more government capital. With the "no bank can fail" thought running opposite to the dilution worry I suspect we are not going to see a big rally in financials until after May 4th. Those passing the test and not in need of more capital are likely to see investors flock to their stock. Since every financial analyst will be handicapping the outcome all week, those stronger banks should see some gains. Those banks are Goldman Sachs, Morgan Stanley, JP Morgan/Chase and US Bank.

The one thing that was evident if you read between the lines the government is NOT going to let anyone return the TARP funds. It wants to keep everyone in the same group and prevent those banks in really good shape from sprinting away from the pack and taking all the clients with them. How they are going to force banks to keep money they don't want until as far out as 2011 is going to be tricky. I guess you could pass a law making it illegal to try and give the money back. I know it sounds absurd but this entire retroactive law situation is absurd.

The market dropped sharply on the announcement because there were no details except what had already been leaked to the press. After a few minutes the market began rebounding again as analysts began calling it "stress test light." The adverse conditions were actually not as bad as had been expected and that caused analysts to downgrade their estimates for how many banks would actually need capital.

Four banks that did not take the test but failed anyway are the First Bank of Idaho, American Southern Bank in Georgia, Michigan Heritage Bank and the First Bank of Beverly Hills. All four banks were closed by regulators on Friday bringing the total failures in 2009 to 28. No assuming bank could be found to take over the Beverly Hills bank and its $1.5 billion in assets. The FDIC will take control and close it. How bad does a bank have to be before no other banks are willing to bid for the deposits? The FDIC said it would cost them $394 million to close the bank. The Beverly Hills bank was the largest of the four and the only one without a takeover candidate.

The economic calendar for Friday had two reports that surprised analysts. The first was the Durable Goods orders for March, which fell -0.8% in March following a 2.1% increase in February. The decline in March was only half what was expected. Shipments fell -1.7% and the eighth consecutive monthly decline. New orders and back orders also declined but the overall headline number was stronger than expected. This is not a sign of a rebound but simply a slowing of the deterioration. You could call it a prelude to a rebound.

New Home Sales came in at 356,000 units on an annualized basis and that was significantly over the consensus estimates of 340,000. The January and February numbers were revised significantly higher and that produced a strong bounce in the homebuilders. Current inventory of 311,000 is less than 11 months of demand and we are rapidly moving into the high sales season. Sales prices have fallen about 12% and demand is improving. Low mortgage rates and deals by builders are helping increase demand.

The economic calendar for next week has some serious events to impact trading. The Richmond Fed Manufacturing Survey on Tuesday will be the first and with improvements in some sectors there will be expectations for some improvement to start showing in all the manufacturing reports. The GDP for Q1 will be revised on Wednesday. The last reading was a -6.34% drop and that is expected to improve significantly to -5%. Any material difference there could cause volatility.

There is a two-day FOMC meeting, which ends on Wednesday and the announcement is expected to keep the Fed Funds rate at about 0.13%. The Fed statements at recent meetings have been lengthy and skillfully tread the path between gloom and boom. The recent Beige Book showed that conditions improved in five of the twelve Fed regions in March so that should be carried over into the FOMC statement. Either way we always expect volatility at the 2:15 announcement.

On Friday we will get the national ISM Manufacturing Index, which combines all the regions and this reading is also expected to improve from 36.3 to 38. Anything under 50 is still in contraction territory. A significant gain or an unexpected decline could roil the markets. Factory orders will also be released and analysts are expecting to see some improvement soon. Inventory levels are becoming dangerously low and the need for a replenishment cycle is growing.

Economic Calendar

Chrysler could be a week away from Bankruptcy. GM maybe a couple weeks. In the midst of this auto turmoil Ford reported earnings that beat the street with a loss of only $1.4 billion. In auto terms that is almost a profit. Ford has $21.3 billion in cash and their $3.7 billion quarterly burn rate for Q1 is expected to be the highest for the year. It appears that Ford is going to avoid taking government money and avoid the bankruptcy facing the other automakers. Ford stock rose +11% on the news.

American Express reported earnings of 32-cents that blew away the consensus estimates of 12-cents. Upgrades were flying and AXP stock spiked 19% on the news. AXP was expected to report gloom and doom because of the decline in credit quality that was previously reported. AXP cut costs drastically and raised their guidance. FBR said expenses were $440 million less than expected. AXP shares even overcame a downgrade from Moody's due to AXP's surprising guidance. This was a dramatic surprise and very positive for the market. Visa and Mastercard both report earnings next week but they are not the same business model as AXP. Mastercard and Visa have no credit risk.

AXP Chart

Next week's earnings calendar is full of second tier companies as company size declines over the next three week reporting schedule. There are always some big companies regardless of the calendar week and Exxon, Chevron, Mastercard, Visa, Etrade, BP, BMY stand out from the list. There are well over 500 companies reporting and the table below is just a representative list of those most well known. After last week's giants the size and quality will decline for the rest of the cycle.

Earnings Calendar

In a sign of the times a company well known for innovation with a brand name everyone would recognize instantly was sold at a bankruptcy auction for $87 million. The Polaroid Company, its brand name and all its assets were sold to two private equity groups even though their bid was $500,000 lower than the first place bid. It was the third time in two weeks that a judge overruled the bidding and forced a do over. The winners have also snapped up other brands including Sharper Image, Linens 'n Things and Ellen Tracy. They plan to revive Polaroid with an expanded array of products and make them the premier digital photo company in the world. That should take a lot more than $87 million to accomplish. When you think about how many billions of dollars of Polaroid cameras, film and other products were sold over the last 50 years it proves that a company that remains stagnant even when they have good ideas is doomed to failure.

Oil prices rallied back from their futures expiration crush, to less than $44 on Tuesday, to close at $51.55 on Friday. You would think that having GM announce the closure of 13 plants for 9 weeks this summer and lay off 24,000 workers would not be bullish for gasoline demand. You would think that a crude oil inventory increase of 20 million barrels over just the last seven weeks to twenty-year highs would not be bullish for prices. If you thought this you would be correct. However, the dollar is crashing. The dollar index, which hit a 7-week high on Monday when oil was crashing, has now declined nearly 3% for the week. That means it takes more dollars to buy the same barrel of oil. The dollar hit a 3-week low on Friday.

The massive amount of government paper coming to market and the rising debt is finally catching up with the strong dollar. Just next week alone there will be $101 billion in coupon bonds auctioned, $57 billion in T-bills, $57 billion in 3 & 6-month notes and $40 billion in two-year notes. This is a staggering amount of debt that will be sold to support all the bailout programs in progress. Remember my comments from several weeks back on what will happen when the first auction fails. We could be getting closer every week. Cheaper dollars equals higher oil prices and institutional investors are buying oil to hedge against the falling dollar. Gold is also falling because the world's financial crisis appears to be easing and that means gold hedges are being swapped for oil. If the global economy improves so will the demand for oil and that is another reason to buy the dips in oil prices.

Dollar chart

Oil chart

Commentator Mark Hulbert had an interesting article this week on the number of new bull markets that go back to test their prior lows after big gains. He analyzed the last 33 bull markets and found that 19 of them (57%) gave up strong double digit gains like we have today and returned to trade within single digit percentages of their prior lows. For instance the Dow rallied +23% in the first 45 days of rebound in 2002 but then returned to within 3.3% of the bear market lows. The Dow is up +22% today after 49 days of gains. Past performance is no guarantee of future results but it does prove that it can happen over and over again.

Another analyst studied the sell in May and go away strategy after bear market bottoms dating back to 1932 and found that 12 of the last 13 saw the market higher six months later and only one would have profited from the sell in May strategy. His recommendation was to buy the dips and expect the market to be 12-13% higher by fall. Personally 12-13% does not sound like much today when the Dow is up +22% and Nasdaq even more after seven consecutive weeks of gains but I think everyone would be glad to see it. Another 13% would only push the Dow to 9150, which just happens to be massive resistance. That would be a likely place to stall with a 35% gain off the bottom.

Dow Chart

The Dow returned to support at 7800 twice last week just to make sure everyone had a chance to buy the dip again. This is textbook support testing but the Dow is not showing the same desire to break through overhead resistance like the Nasdaq. The financial stocks in the Dow gave it a major boost off the March 31st low but the closer they got to earnings and the stress test the more lethargic they became. Next week is not likely to be any better as the winners and sinners are cussed and discussed all week and given multiple views for reaction after the May 4th "applicable" results are released by the White House. This may keep the Dow on a short leash unless the FOMC announcement turns bullish.

Another 13% gain on the Nasdaq would push it to just over 1900 and in clear breakout mode over all resistance dating back to October. The Nasdaq closed above strong resistance once again at 1694 and looking stronger every day. Microsoft rallied over 10% after reporting the first decline in quarterly profits in their 23-year history and saying the recovery would be slow. The dip buyers in tech stocks are alive and well. Support on the Nasdaq is now 1600 and I would be surprised if it broke next week.

Nasdaq Chart

The S&P is mimicking the Dow and can't quite seem to breakout to new highs while dragging quite a few stocks with poor earnings and poor guidance. The financials are not exploding and probably won't for another week so the S&P could struggle some more. This is the week for oil stocks to report and you can bet that profits are going to be sharply lower than Q1 last year. This could depress the S&P but it really depends on the outlook these stocks give and the stress test commentary we are going to have to endure all week. Support is 820 and resistance 875.

S&P Chart

The Russell has a strong pattern of higher lows but did not quite make it over the 480 resistance level on Friday. This resistance level held last Friday, again on Wednesday and again this Friday. This resistance dates back to late January and early February but I think it is doomed in the week ahead. If we can get a strong jump out of the box on Monday the Russell and Nasdaq should drag the other lackluster indexes along with them.

Russell Chart

The biggest event in the coming week is the FOMC meeting. Nobody expects any sudden changes in policy by the Fed BUT real interest rates are climbing back to around 3% as though they were daring the Fed to do something about it. This suggests the Fed will pull another rabbit out of their hat when they announce at 2:15 on Wednesday. Who knows what it will be because they have already used up all the ammo for several of their major weapons. They are going to need to be creative but avoid scaring investors with the magnitude of their plan. I am still in buy the dip mode and for traders that dip back to Dow 7800 was picture perfect. We are going to keep using this strategy until it fails and hopefully that will be a long way off. Since hope is not a strategy we do need to keep a watchful eye for that dip that does not stop as expected. I would still love to see that 10% correction I discussed before, which would take the Dow back to 7200 but I don't see it in the cards for next week. Anything is possible but not always probable. Buy the dip to 7800 followed by 7500 if it happens.

Jim Brown